Hurricane season is here, but not all hurricanes are alike, according to the Tax Court. In a recent case (Carter v. Commissioner, T.C. Summ. Op. 2012-33, April 17) the court ruled that a couple owed the 10% early-distribution penalty for a withdrawal from the husband's qualified retirement plan even though the money was used to repair property damaged by Hurricane Ike and to replace income lost due to that storm. On Sept. 13, 2008, Hurricane Ike made landfall in Galveston, Texas, as a Category 2 storm. Texas' Hardin County was in the hurricane's path and was later designated a federal disaster area. As a result, the Internal Revenue Service had the authority to give its residents more time to complete certain acts, such as arranging individual retirement account rollovers, correcting certain excess contributions and filing certain tax returns. When Ike hit, Jeffrey Carter and his wife lived in Hardin County. Later that year, they took a $20,000 early distribution from his qualified retirement plan to repair property damaged by the storm and to supplement income that they lost because of the storm. They properly paid federal income tax on the early distribution, but they claimed an exception to the 10% early-distribution penalty because of the hurricane by filing IRS Form 5329. The IRS disagreed, claiming that there was no such exception and determined that the Carters were subject to the 10% penalty. When the two sides couldn't agree, they ended up in Tax Court.
The court ruled in favor of the IRS, finding that the Carters owed the 10% penalty. The couple argued that because the government exempted the 10% early-distribution penalty for victims of other hurricanes and for storms in the Midwest, it was only fair that they be given the same exemption. Although the court sympathized with the Carters, it couldn't waive the 10% penalty. Hardin County wasn't included in the Midwestern Disaster Area for 2008 when Mr. Carter took his early distribution, despite the fact that the area was a federally declared disaster area. Because Congress didn't explicitly extend the tax breaks to victims of Ike, the early distribution wasn't a qualified disaster recovery assistance distribution, and the 10% penalty applied. Although the Carters' situation may have ended unfavorably, over the years, other victims of a natural disaster have been able to take distributions from their retirement accounts without incurring the 10% penalty. One type of relief came when Congress authorized the IRS to allow victims of three specific hurricanes to make qualified retirement plan distributions for a specific period of time. For example, a qualified hurricane distribution was permitted for Katrina, the hurricane that devastated New Orleans in August 2005. Distributions taken by affected taxpayers between Aug. 25, 2005, and Dec. 31, 2006, were exempt from the 10% early-distribution penalty and taxed over a three-year period, with a repayment period extended over three years. In order to qualify for these special breaks, the individual must have suffered an economic loss as a result of the hurricane. These tax breaks applied to distributions from both employer plans and IRAs. Similar tax breaks were extended to victims of Hurricanes Rita and Wilma. In 2008, Congress expanded its relief to other natural disasters. As a result of significant tornadoes in Kansas in 2007, the special tax treatments previously given to qualified hurricane distributions were extended to the Kansas Disaster Area. Since then, these tax breaks have extended to the Midwestern Disaster Area of 2008. Those distributions were known as “qualified disaster recovery assistance.” The IRS can postpone certain tax deadlines for individuals affected by federally declared disaster areas. When any deadline is postponed, the IRS issues a news release or other information in the Internal Revenue Bulletin and on its website. But the IRS can't exempt certain distributions from the 10% penalty unless there is a change in the law, and only Congress can do that. Financial advisers shouldn't assume that clients who suffer an economic loss as a result of a federally declared disaster area will qualify automatically for the special tax breaks that apply to qualified disaster recovery assistance distributions. This is true even when the IRS postpones tax deadlines as a result of a disaster. Ed Slott, at irahelp.com, is a certified public accountant and IRA distribution expert.
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